Profit Streams

1. Suppose that the total benefit and total cost from an activity are, respectively, given by the following equations: B(Q) =100+36Q-4Q 2 and C(Q)=80+12Q.

a) Write out the equation for the net benefits.
b) What are the marginal net benefits when Q=2? Q=6?
c) What level of Q maximizes net benefits?
d) At the value of Q that maximizes net benefits, what is the value of marginal net benefits?

2. What is the value of a government bond that pays a perpetual dividend of $320 at the end of each year when the interest rate is 8 percent?

3. Microsoft is considering moving 1,000 employees from a help-desk call center in Seattle to Bombay. The total after-tax cost of a Seattle worker is $50,000 per year and the total after tax cost of a Bombay worker is $30,000 per year. The move would require paying an upfront severance package worth $40,000 after taxes per former Seattle employee.
Assume for this analysis that the cost savings would last forever and that Microsoft’s cost
of capital is 20%.
a) Should the project be accepted based on the NPV rule?
b) Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.
Internal rate of return is used to evaluate the attractiveness of a project or investment.
What is the IRR of the project?
4. You have just been hired as a consultant to help a firm to decide which of three options to take to maximize the value of the firm over the next three years. The following table shows year-end profits for each option. Interest rates are expected to be stable at 8 percent over the next three years.

Option Profit in Year 1 Profit in Year 2 Profit in Year 3
A $70,000.00 $80,000.00 $90,000.00
B $50,000.00 $90,000.00 $100,000.00
C $30,000.00 $100,000.00 $115,000.00

a. Discuss the difference in the profits associated with each option. Provide an example of real-world options that might generate such profit streams.

b. Which option has the greatest present value?

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